- Compliance Obligations under the U.S. Internal Revenue Code
I. Introduction
In the early 1960’s a series of rules were added to the Internal Revenue Code that required U.S. Corporations to pay tax, in certain instances, on the income of their Foreign Subsidiaries. This obligation to pay taxes was mandatory whether the U.S. Corporation received the income in a form of dividend or not. The income was referred to as “Subpart F" income. Since the 1960’s, the rules surrounding Subpart F income have become increasingly complicated and contain a mine field for the unwary.
The Subpart F rules apply to Foreign Controlled Corporations (CFC’s). A foreign company is a CFC if more than 50% of the voting stock is owned by U.S. person or persons. (The definition of a U.S. person includes any U.S. resident, corporation, partnership, or trust).
In the years following the implementation of Subpart F rules the reporting requirements of CFC's operations has increased. Numerous filings and elections are required in which the taxpayer must disclose, not only foreign income and expenses, but information about contributions to the foreign entity by the U.S. person; sale of inventory, transfer of intellectual property, and loans. (If the U.S. person fails to sell, license, or loan money at the same rate as it would to an unrelated person, this failure may result in substantial penalties potentially up to 40% of the value of the transaction). Initially, the IRS required only an information return for CFC’s; Form 5471. However, in 2001 the IRS introduced a new reporting requirement for foreign partnerships that are directly or indirectly controlled by by U.S. persons; this form is Form 8865. Failure to file either the 5471 or the 8865 may result in a penalty of $10,000 per violation.
II. Foreign Operations
Foreign operations typically occur in either a form of a corporation, partnership or branch. (It should be noted that a U.S. person may file an election to treat a controlled foreign entity as a corporation, partnership or branch, regardless of its form under the law of the country in which it operates). The partnership and branch were considered to be disregarded entities. Disregarded, in that prior to 2000, there was no filing requirements. However, as noted above, a U.S. person must now file Form 8865, including a K-1 form, for direct or indirect ownership of more than 50% of the foreign partnership by a U.S. person or persons. Branch operations do not have any reporting, however, the income must be included in the return of the CFC or Domestic Corporation. III. U.S. Filing of Foreign Operations From 2001 on information return must be filed for foreign CFC’s and controlled foreign partnerships. These forms are 5471 and 8865 respectively. These forms have a series of schedules which require disclosure of income and expenses; beginning and ending balance sheet; Earnings and Profits adjustments; subpart F income; intercompany transactions and changes in ownership. Upon filing the initial return the filer must determine the functional currency of the entity being reported. Conversion of foreign currency is subject to a complex set of rules. Generally, the income and expense schedule is converted into U.S. dollars based on the weighted average rate of the exchange rate for the tax year. (The weighted average is the daily exchange rate for the year averaged by the number of business days. The balance sheet is converted based on the year end rate. However, special rules apply to conversion of foreign taxes and certain income, expense, accounts payable and receivable that are in a non-functional currency. The rules require a separate accounting for these non-functional currency transactions IV. Earnings & Profits While there is no definition of Earnings & Profits in the Internal Revenue Code, it is for reporting purposes net income that has been adjusted. The adjustments in Schedule H, of form 5471 include: Each of the above has special rules as to how each is calculated. For financial reporting purposes, it is permissible to use accelerated depreciation, however the E&P rules require straight line depreciation and the life of each class may differ from those for financial reporting purposes. Accordingly, an adjustment must be made to E&P to reflect the difference. Earnings and Profits must be tracked for all years that an entity is a CFC. Recently, new rules have been introduced concerning the treatment of E&P prior to an entity being a CFC, the merger of a non-CFC into a CFC or acquisition of a non-CFC. Special pools must be maintained and segregated from the accumulated E&P. Any current year distribution will be deducted from current year E&P, and if the distribution exceeds current year E&P then it will be taken from accumulated E&P. It is necessary to maintain E&P by source (Basket). Included in E&P, will be previously taxed E&P, such as Subpart F income, that must be tracked by source (basket) as well. The Internal Revenue Code has special rules relating to the Allocation & Apportionment of a U.S. parents Interest expense, Research & Development expense, and Stewardship. Like E&P, these expenses are allocated to or among related entities, including foreign CFC’s and foreign partnerships by source (basket). Interest expense, Research & Development and Stewardship have detailed rules as to how these are to be allocated and apportioned. Further, the impact of the allocation & apportionment of these expenses can cause a loss by source(basket) and may cause, upon sale or dissolution of that entity, a recapture of the loss in any basket, which is recognized as income in the year of sale or dissolution by the U.S. parent. V. Subpart F Income Certain income of a CFC may be Subpart F, and thus characterized as a "deemed dividend" to the U.S. parent which will be included in the U.S. parents current year income. Subpart F income includes sales of inventory outside of the CFC’s country of operation; certain interest, rents, royalties and dividend income; service income, and shipping income on behalf of related parties that does not fall within any exception, contained in the Internal Revenue Code. Extensive analysis must be made of the company earnings to determine if there is an exception to the "deemed dividend" inclusion. One example is the same country exception for dividends from related company. The rules require that more than 50% of the assets of a dividend recipient be located within the country of its incorporation. Many issues can arise relating to location of inventory; accounts receivable; ownership of subsidiaries outside the country of the recipient that may prevent the application of the same country exception. If it is determined that there is Subpart F income it must be grossed-up to include the portion of local foreign taxes for inclusion in the U.S. parents current year income. (The grossed up amount is the Subpart F income plus taxes). The U.S. parent would be entitled to a foreign tax credit (FTC) on that income. However, the credit would be subject to the limitations in the Internal Revenue Code and may not, in all instances, be creditable against U.S. tax. It is also important to note that there will not be any Subpart F income, if there is no current year E&P. V1. Related Party Transactions Both Form 5471 and 8865 require that all intercompany transactions be detailed in Schedule M. The transactions include, purchase and sale of inventory; loans which create interest income or expense, royalties, rent, income/expense from services and dividends. As noted earlier, these transactions are subject to substantial penalties under the Transfer Pricing rules of Section 482. Schedule M becomes a road map for the IRS during audit and may generate from the IRS requests for all documentation relating to those transactions. The taxpayer has the burden of proving that the rate charged or paid is at arm’s length. It is therefore important to document all related party transactions each year and to maintain that documentation for audit. VII. Contributions to Foreign Subsidiaries The taxpayer must file with it’s Form 5471 Form a Form 926 detailing any and all contributions made to a CFC by a U.S. person. The form requires the date of such transfer, description of what was transferred and value of any non-cash asset. In certain cases, if appreciated property is transferred to a foreign CFC, the taxpayer may wish to file an election which includes a Gain Recognition Agreement. The election is for 5 years and the taxpayer defers recognition of the any gain on the appreciated property until it is sold or otherwise disposed of by the foreign CFC during the 5 years . Each of the 4 years after, the initial filing an additional notice must be provided stating that the appreciated property has not been sold or disposed by the foreign CFC. No Form 926 is required to be filed by a foreign partnership. Form 8865 includes a schedule which replicates form 926. VIII. Foreign Bank and Financial Accounts A form TD 90-22.1 must be filed with the Treasury Department and included with the Form 5471/8865 detailing each foreign bank and financial accounts for each foreign CFC and controlled foreign Partnership. The form requires listing of each account, the financial institution and highest balance. If there are more than 25 such accounts, the taxpayer is allowed to provide the detailed information upon request. However, it is necessary to maintain in the file a complete list of all foreign bank and financial accounts. IX. Boycott Report If a foreign CFC or controlled foreign partnership has any business transactions with any member of the Arab League it must file Form 5713. The purpose of this form is to determine whether any member of the Arab League has requested the foreign CFC or controlled foreign partnership to participate in or sign a statement, boycotting Israel. Under the Internal Revenue Code, a foreign CFC or controlled foreign partnership’s foreign taxes will not be credible for the U.S. parent. Credible taxes are those foreign taxes a U.S. parent may use to lower it’s U.S. tax liability on Form 1118. Further, the Department of Commerce requires disclosure by a U.S. parent of participation in or execution of any document relating to the Boycott of Israel. The penalties under the Commerce Department are separate from those imposed by Treasury Department. X. Foreign Tax Credits U.S. taxpayers are allowed a credit for foreign taxes paid or accrued on foreign source income. The credit is limited to that part of U.S. tax generated by foreign source taxable income. A concept of limiting foreign tax credits separately for each of the sources or "baskets" of income as listed below: A dividend from a more than 50% subsidiary is characterized the same as the underlying income of the subsidiary. One must track income from each of these baskets separately for each CFC. Further, one must also allocate and apportion deductions to each basket in order to compute net taxable income in each basket. It is recommended that the general ledger should contain enough information to track the separate baskets. However, further analyses may required for foreign sourcing of sales. Foreign source income is gross income less applicable deductions. Foreign gross income includes: Foreign source income and deductions must be segregated by basket and country. Apportion deductions such as interest and R&D, only among baskets that have income. Allocations and apportionment can be done on supporting work papers. XI Baskets and Deduction The E&P of a CFC must be tracked by basket for any foreign entity that U.S. person owns more than 50. This requires not only tracking gross income, it also requires allocation and apportioning at the foreign entity level. XII. Gross Income Sourcing Foreign source income is the starting point in computing foreign tax credit limitations. It must be separated by type of income, country, and basket for Form 1118. However, income from multiple countries may be combined using the Other Countries code..Interest and dividends from foreign entities are generally foreign source. The source of rent and royalty income is the country where the property is situated or used. XIII Foreign Tax Credit Limitation U.S. Taxpayers are allowed a tax credit for foreign taxes paid or accrued on foreign source income. However, the credit is not dollar for dollar against U.S. taxes. It is limited as a ratio of Foreign Income to World Wide income as the formulae below indicates. The Foreign Tax Credit however is allocated by basket, and therefore to the extent there may be a loss in any particular basket, no credit will be allowed. However, if there any any prior years(s) losses in any basket, that may offset current income and no foreign tax credit may be available. 